Saturday, June 9, 2012

Léon Walras and General Equilibrium

There are obviously differences between what Alfred Marshall meant by equilibrium and what neoclassicals like Walras meant by it, but general equilibrium can be defined as a situation where all markets, including the labour market, clear at the same time. It can also be called a “full employment equilibrium.”

A question that immediately occurs is this: did Walras think general equilibrium is ever attained in the real world?

Apparently not:

“Equilibrium in production, like equilibrium in exchange, is an ideal and not a real state. It never happens in the real world that the selling price of any given product is absolutely equal to the cost of the productive services that enter into that product, or that the effective demand and supply of services or products are absolutely equal. Yet equilibrium is the normal state, in the sense that it is the state towards which things spontaneously tend under a régime of free competition in exchange and in production.” (Walras 1954: 224–225).

“Such is the continuous market, which is perpetually tending towards equilibrium without ever actually attaining it, because the market has no other way of approaching equilibrium except by groping, and, before the goal is reached, it has to renew its efforts and start over again, all the basic data of the problem, e.g. the initial quantities possessed, the utilities of goods and services, the technical coefficients, the excess of income over consumption, the working capital requirements, etc., having changed in the meantime. Viewed in this way, the market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it. But whereas there are days when the surface of a lake is almost smooth, there never is a day when the effective demand for products and services equals their effective supply and when the selling price of products equals the cost of the productive services used in making them. The diversion of productive services from enterprises that are losing money to profitable enterprises takes place in various ways, the most important being through credit operations, but at best these ways are slow. It can happen and frequently does happen in the real world, that under some circumstances a selling price will remain for long periods of time above the cost of production and continue to rise in spite of increases in output, while under other circumstances, a fall in price, following upon this rise, will suddenly bring the selling price below cost of production and force entrepreneurs to reverse their production policies. For, just as a lake is, at times, stirred to its very depths by a storm, so also the market is sometimes thrown into violent confusion by crises, which are sudden and general disturbances of equilibrium. The more we know of the ideal conditions of equilibrium, the better we shall be able to control or prevent these crises.” (Walras 1954: 380–381).

A point that emerges is this: the differences between those Austrian economists who adhere to the view of a strong tendency to general equilibrium in the real world (even if it is never attained) and neoclassicals are greatly exaggerated, for even Walras himself believed the same thing: the state of general equilibrium is an ideal, not “a real state.”

I think important conceptual distinctions should be made between the following:

(1) the state of general equilibrium (which never exists in the real world);

(2) a strong tendency to general equilibrium in the real world. This means market processes are moving in that direction normally and consistently as a natural condition. These processes are “equilibrating mechanisms,” and it is their combined effective operation that creates a strong tendency to general equilibrium;

(3) The “equilibrating mechanisms” or “coordinating mechanisms” should not simply be identified with the actual tendency to general equilibrium in the real world. The latter is a distinct phenomenon, whose existence Post Keynesians would deny.

The “equilibrating mechanisms” for Austrians and neoclassicals are regarded as things such as an equilibrium rate of interest clearing the loanable funds market, equilibrium prices, Say’s law, the tendency of the rate of profit to become uniform, entrepreneurship seeking profit, speculative arbitrage, significantly and quickly flexible wages and prices, and so on.

It can be seen that some of these alleged “equilibrating mechanisms” do not even exist: the equilibrium rate of interest and Say’s law, for example. Others do not actually happen in the real world, such as rapidly adjusting wages and prices.

Of course, even Post Keynesians would not deny that there do exist certain coordinating mechanisms. But the issue is whether the ones that do exist really work in the way imagined by neoclassicals and Austrians.

The alleged combined effective operation of these “equilibrating mechanisms” is really a myth, and so is the strong tendency to general equilibrium.

The fundamental insight of Keynes was that, even if we had perfectly flexible wages and prices, market economies would still not necessarily converge to full employment equilibrium. Significant unemployment could still exist even with perfectly flexible wages and prices.

The insight of Irving Fisher and Hyman Minsky was that price deflation in an environment of high private debt causes debt deflation.

Post Keynesians argue that there is nothing in market systems that ensure that the economy will converge automatically to full employment equilibrium (Davidson 1993: 436). This does not mean that free market economies are inherently disequilibrating, however (Davidson 1993: 436). For Keynes, the most serious flaws in capitalism were as follows:

“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” (Keynes 1936: 372).

No doubt there are more radical criticisms that could be made of capitalism, but it is important to make clear what Keynes thought.

Keynes regarded the “unemployment equilibrium” (which is better called an “unemployment disequilibrium”) as capitalism’s natural state:

“our actual experience … [sc. is] that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.” (Keynes 1936: 254).

Keynes’s view was that real-world capitalist systems have a tendency to fluctuate around a state well below full employment: this is a major and serious problem of market economies.

2 comments:

Brilliant post. You masterfully illustrate the contrast between neoclassical and Keynesian economics.

"Significant unemployment could still exist even with perfectly flexible wages and prices."

True, and there's a reason for that: when people can't afford to buy the goods/services being produced under an economy at equilibrium, growth is weak as a result, as investors have no incentive to hire and create jobs.

"Yet equilibrium is the normal state, in the sense that it is the state towards which things spontaneously tend under a régime of free competition in exchange and in production."

This is basically all a case of whether you believe in teleology or not. Most philosophers (outside of theology) and scientists do not and opt for a more evolutionary perspective. But the neoclassicals insist on their intelligent design nonsense.

Personally, I'd like to get away from the idea of equilibrium itself. I think that's the direction Robinson was moving in. Frankly, I think you can do economics perfectly well without thinking in terms of equilibrium or disequilibrium. The economy, contra Walras, is not a lake -- either a stormy lake or a tranquil one. Instead it is a series of processes that are constantly transforming one another and giving rise to new processes. Marx fundamentally understood this, I think -- and it was due largely to his reading of Hegel.